Measuring retirees’ real cost of living

Jeffrey B. Miller is Professor of Economics Emeritus at the University of
Delaware. He earned his doctorate from the University of Pennsylvania in 1976
and taught at the University of Delaware for 36 years. In
2009 he co-founded Social
Security Choices, a firm that specializes in providing customized
information to assist people in formulating their best strategies for claiming
Social Security benefits. Dr Miller worked at Social Security after graduating
from college.
JMiller@socialsecuritychoices.com

CORRECTION: An earlier version of this column incorrectly referred to the CPI-W as the CPI-U.

The Social Security Administration recently announced that retirement benefits will increase by 1.5% in January 2014, one of smallest cost-of living adjustments (COLAs) since they became automatic in the 1970s. Presently the COLA used to adjust Social Security benefits is the CPI-W, which is created by doing a survey of retail prices based on the consumption profile for urban wage earners and clerical workers. Although this year's calculation resulted in a small adjustment, economists generally agree that the COLA measure overstates the actual changes in the cost-of-living.

How the COLA is determined has serious consequences for both individuals and government.

The COLA is the reason Social Security provides almost unique protection against inflation for workers. Without the COLA, the Social Security benefit of a worker who retired in the 1980s would have only about half the purchasing power it has today.

For government, even small changes in the method of the COLA calculation can mean billions of dollars over the coming decades. For this reason, potential changes in how the Social Security COLA should be measured are an important part of the current policy debate over taxes and spending. Despite opposition within the Democratic Party, President Obama has proposed changes to the measurement of the cost-of-living as a way to bring down spending.

The president's proposal is for a chained index. Unlike the present measure, a chained index takes into account changes in the market basket of goods that people consume when relative prices change. For example, if orange juice prices spike because of a drought in Florida, some people will substitute other juices for orange juice. A chained index will reflect this change when it measures inflation; the present measure does not.

Taken on an annual basis the difference between adjusting benefits using the present measure and a chained index would be small. As RetireMentor Jason Fichtner has pointed out, the Social Security Administration estimates that the difference will be 0.3% a year. The Congressional Budget Office (CBO) estimates that it will be only 0.25% a year. In other words the increase in benefits might be 1.5% using the present measure versus 1.25% with a chained-index. These differences are small in the first year the adjustment is made and amount to only a few dollars’ difference, but the effects would be compounded over time and become larger as time passes. After 30 years, for someone retiring today, the benefits would be approximately 8% lower under the chained index.

The basic problem with using either the current method or the chained index is that they are based on the consumption profile for urban wage earners and clerical workers, not retired seniors. Increased need for health care and the different housing situations seniors generally face suggest that these two elements of their 'market basket' can be quite different from those of younger people. What is needed, therefore, is an inflation measure based on the good and services that seniors actually consume and uses the new chained-index methods for calculating price level changes. Only then would the adjustments to Social Security be fair.

A promising experimental index, CPI-E, measures cost-of -living changes for the elderly. Since the early 1980s, the CPI-E has generally risen faster than the measure presently used to adjust Social Security benefit levels.

That changed after the 2008-09 recesesion. The CBO believes that the reason that the CPI-E has been rising more slowly in recent years than the CPI-W is the decline in housing prices; it also believes that the CPI-E will rise more rapidly than the CPI-W in the future.

It is difficult to judge how accurate the experimental CPI-E really is since it is not based on the proper surveys that would lead to a more accurate measure of the degree of inflation that retired workers experience. The missing ingredient of a formula that properly adjusts Social Security benefits is a properly calculated CPI-E, which can then be adjusted using a chained index. This is the most promising method of protecting elderly Americans against future inflation.

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